Put Backspread

The put backspread (reverse put ratio spread) is a bearish strategy in options trading that involves selling a number of put options
and buying more put options
of the same underlying stock and expiration date
at a lower strike price. It is an unlimited profit, limited risk options trading strategy that is taken when
the options trader thinks that the underlying stock will experience significant downside movement in the near term.

Put Backspread Construction

Sell 1 ITM Put Buy 2 OTM Puts

A 2:1 put backspread can be implemented by buying a number of puts at a higher strike and buying twice the number of puts at a lower strike.

Limited Risk

Maximum loss for the put backspread is limited and is incurred when the underlying stock price at expiration
is at the strike price of the long puts purchased. At this price, both the long puts expire worthless while the short put expires in the money. Maximum loss is
equal to the intrinsic value
of the short put plus or minus any debit or credit taken when putting on the spread.

Example

Suppose XYZ stock is trading at $48 in June. An options trader executes a 2:1 put
backspread by selling a JUL 50 put for $400 and buying two JUL 45 puts for $200 each. The net debit/credit taken to enter the trade is zero.

On expiration in July, if XYZ stock is trading at $45, both the JUL 45 puts expire
worthless while the short JUL 50 put expires in the money with $500 in intrinsic
value. Buying back this put to close the position will result in the maximum loss
of $500 for the options trader.

If XYZ stock drops to $40 on expiration in July, all the options will expire in
the money. The short JUL 50 put is worth $1000 and needs to be bought
back to close the position. Since the two JUL 45 puts bought is now worth $500 each,
their combined value of $1000 is just enough to offset the losses from the written put. Therefore,
he achieves breakeven at $40.

Below $40 though, there will be no limit to the gains possible. For example, at
$30, each long JUL 45 put will be worth $1500 while his single short JUL 50 put
is only worth $2000, resulting in a profit of $1000.

If the stock price had rallied to $50 or higher at expiration, all the options involved will expire worthless. Since
the net debit to put on this trade is zero, there is no resulting loss.

Note: While we have covered the use of this strategy with reference to stock options, the put backspread is equally applicable using ETF options, index options as well as options on futures.

Commissions

For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.

However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).

Similar Strategies

The following strategies are similar to the put backspread in that they are also bearish strategies that have unlimited profit potential and limited risk.

Protective Call

Long Put

Ratio Spread

The converse strategy to the backspread is the ratio spread.
Ratio spreads
are used when little movement is expected of
the underlying stock price.

Call Backspread

The backspread can also be constructed using calls. Unlike the put backspread,
the
call backspread is a bullish strategy.

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